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Can Samsung Recover From the Galaxy Note 7 Disaster?

The Galaxy Note 7 line has officially been axed. What does it mean for Samsung, and who could benefit from the fallout?

Samsung's (NASDAQOTH:SSNLF) official recall of the Galaxy Note 7 line earlier this month solidified the product as one of the biggest tech flops in recent memory.

In this week's Industry Focus: Tech, The Motley Fool's Dylan Lewis and contributor Evan Niu discuss what we know about the Note 7 explosions, how Samsung's stock has been affected so far, how the company might recover from this, and how much this might hurt the business going forward. On the other side, the duo take a look at some companies that could benefit as they take up Samsung's slack.

A full transcript follows the video.

This podcast was recorded on Oct. 14, 2016.

Dylan Lewis: This episode of Industry Focus is supported by Wunder Capital, an investing service that allows individuals to invest in solar projects across the United States. Earn up to 11% annually while diversifying your portfolio, curbing pollution, and combating global climate change. Create an account for free at wundercapital.com/fool. Wunder Capital: Do well and do good.

Welcome to Industry Focus, the podcast the dives into a different sector of the stock market every day. It's Friday, Oct. 14, and we're talking about the fiery mess that is the Samsung Galaxy Note. I'm your host, Dylan Lewis, and I'm joined on Skype by Fool.com senior tech specialist, Evan Niu. Evan, how's it going?

Evan Niu: It's been a fun time to watch Samsung, considering I've been a longtime Samsung skeptic.

Lewis: We're both Apple(NASDAQ:AAPL) guys, we're both iPhone guys, so I think it's been comforting for us to know that the phones in our pocket are not going to spontaneously combust any time soon, right?

Lewis: On today's show, we're going to give a little rundown on what's been going on with Samsung and the Galaxy Note line over the last month-plus, how that line fits into the company's smartphone segment, and the company's financials in general. Then, which companies, if any, might benefit from some of the backlash and the recall of the Galaxy Note line.

Evan, you want to get us up to speed, give us a little timeline on what's been going on?

Niu: Sure. Galaxy Note 7 launched in mid-August. I think that was part of the deal -- Samsung was really wanting to beat Apple to market on timing, because, as everyone knows, iPhones come out in September. So, I think the company was really pushing toward the timeline of getting this thing out to market as quick as possible to try to beat Apple to the punch. Which is kind of silly, because it's only a month difference. How much of a difference could that make? But, apparently, that was important to Samsung. I think that's partially what's led up to these problems, they cut corners or tried to do things too fast. Things obviously just weren't ready. Then, as we know, in early and mid-September, we started to see reports of Samsung Note 7 either exploding or catching on fire, a lot of the time while they were charging. In general, sometimes you hear stories about this happening. When you're using a third-party charger that's not up to spec, that can sometimes be the culprit. But these were the official chargers, the regular Samsung chargers you were supposed to be using.

So, Samsung does this huge recall, 2.5 million units. They think they figured out that it's the batteries that they sourced in-house from the Samsung SDI internal battery division. So, they do this recall. They leave all the other phones out there that have different batteries from third-party suppliers. They start replacing phones. And now, all of the sudden, in the past week or two, the replacement phones are now catching on fire. (laughs) So, everything is a huge mess, and now they've made the call to officially kill the project altogether. That's a tough call to make, but you have to do it when it's this bad.

It's crazy, because in modern smartphone times, people take this stuff for granted. Before this one, you hadn't heard about an exploding phone, or a phone catching on fire, meaningfully, in years. At least, not at this scale, outside of isolated incidences, like the third-party charger thing I was talking about. But, you don't see this wide-scale type of thing happening. It's been years. I think most consumers have probably thought that companies have figured this out, but apparently they haven't. It's kind of crazy.

Lewis: Yeah, still running into some issues on the tech side. This is, I think, brutally bad timing, given that the company is basically coming off its best earnings report in a couple years. It seemed like they had a ton of momentum, decent amount of growth in the smartphone space. Earlier this week, when the company decided to go with the full recall, they also issued an update to guidance. So, we don't even really have to speculate as to what the financial hit might look like, we can look at exactly at what the company said here. They are now expecting third-quarter operating profit to come in at 5.2 trillion South Korean won, which is roughly $4.6 billion, down from the original forecast of 7.8 trillion won. So, a decent amount of rollback there. Third-quarter revenue has also been revised down. It's now expected to be about 47 trillion won from the previous guidance of 49 trillion won.

Niu: I think what's even more disconcerting about this whole thing is, Samsung still doesn't know what's wrong with the phones. They cannot figure it out. As recently as last week, there was a New York Times report that their engineers are still trying to replicate the problem, and they can't. That doesn't inspire a lot of confidence. It's one thing if they do this recall, they get the phones back, and they figure it out and presumably fix it. But, if they don't even know what's wrong, that's a huge question mark. It really calls to question all these other things about their future phones. I don't think any of their phones have had this type of problem, but going forward, unless they can figure this out and definitively say, "This is what caused it, and we have a solution ... "

This is totally unrelated, but hilarious. They also had washing machines that are now blowing up. I don't know if you saw that. A couple weeks ago, there were reports -- because, Samsung makes everything, and they have these top-load washing machines, and those are now exploding. Clearly, it's a totally different thing, because those don't use lithium ion batteries like the phones do. But it's kind of like, what's going on with everything?! (laughs) Washing machines, too?

Lewis: To layer on top of that, I think there are another couple reasons why this is a little bit different than your average product recall, or even food-safety-related issues, like what we've seen with Chipotle or Jack in the Box in the '90s. You talked about how they haven't been able to diagnose the problem, which doesn't inspire a lot of confidence in the other products they have out there.

I think one of the other issues is, there's a lot of confusion in the Galaxy line. You look out at Samsung's product offering, frankly, it's really hard to keep all their phones straight. They intentionally moved the Note to be on the 7 naming convention, to keep it consistent with the other offerings. Now, I think you're seeing people that aren't 100% sure which products are safe, and which aren't. I saw news that they had to push notifications, I forget which product, but it was one of their newer and higher-priced phones, that --

Niu: It was the regular S7.

Lewis: Right. That, those were not part of the recall, and the people who held those in their hands, if they were reading this notification, didn't need to worry about that. That's fine, but when you have a super fragmented offering, and a lot of the headlines are "Galaxy 7," and they're trying to distill it down to something like that ...

Niu: Yeah. For average consumers who don't follow this stuff as closely as we do, they just see some headline about Galaxy something, 7 something. There's a Galaxy S7, there's a Galaxy S7 A, there's the Galaxy Note 7. There's so many, and they're all part of the Galaxy brand that Samsung has put so much money into building. They put tens of millions of dollars into building this brand over the past five or 10 years. And now, this one horribly botched product risks killing all that brand value. It's not uncommon for Samsung to spend more money on marketing, advertising, kickbacks, commissions to retailers and all that, than it does on R&D. It puts a ton of money into this, and now, because they're unified, they're all getting dragged down. They're trying to contain this thing, like you said, notifications saying, "Your phone is safe." It sounds exactly like the phone is not safe. But, "The phone is safe, don't worry."

Lewis: I think one of the other things that makes this tougher -- and returning back from this a little tougher -- is the product life cycles of smartphones. You look at a place like Chipotle, fast casual, they're able to give away a ton of free product via coupons, Chiptopia, that kind of stuff, and get people back in restaurants relatively quickly, because meals are a routine purchase for people. Smartphones are not. You're buying a phone every two years. Once you get someone in an ecosystem, the likelihood of them staying there is a lot higher. So, I worry there's going to be this class of people coming onto smartphones, or maybe people that recently decided to make the switch over to the Galaxy line, specifically the Galaxy Note line, that they're second-guessing it, might go with another Android device, might decide to go over to something on the iOS side.

Niu: Yeah. That's exactly the thing they need to figure out. Samsung is really good at hardware. Samsung has tried so hard over the past 10 years to get better at software, but of course, they have to get Android from Google, and they do their whole modifications and tweaks, this stuff they put on top of it to try to differentiate. But the point remains that Samsung isn't actually good at that stuff. Their software is not very good. They're really good at hardware. If all the sudden, their hardware is having all these problems, there's really not a good reason to buy a Samsung phone. Historically, their hardware has been incredibly well-made. But now, there's no reason. If their one strength is now being called into question ...

Lewis: People are going to go elsewhere.

Niu: Exactly. And, even if you want to stay with an Android, there's tons of really good Android phones out there.

Lewis: I think, to help adjust for this a little bit, Samsung is offering customers about $75 to trade in their devices for other Samsung models. That's a good retention effort. They might save some lost customers along the way. But it wouldn't be surprising to see some flight from the brand.

One of the other reasons I think this is troubling is the timing in the calendar year. This is ahead of the holiday season, and it's the biggest time of the year for consumer electronics. To have to wipe out an entire product line ahead of the quarter where you're probably going to be doing 40% of your business, at least ...

Niu: Yeah. This is the time, holiday shopping season. Everyone makes all their money here. And now, Samsung has to pull one of their flagship...the Note 7 has been a differentiator compared to the iPhone for a long time, because it comes with a stylus, it's bigger. It was like the posterboy for phablets. Samsung has established itself as the phablet leader, and Apple now has the 7 Plus, which isn't as big as the Note 7 and doesn't have a stylus. But other than that, it's pretty comparable, as far as giant phones go.

Lewis: Yeah. I started briefly introducing what the company was expecting for revenue writedown and revised guidance. It looks like analysts were expecting the company to ship about 15 to 19 million units from Q3 2016 through Q1 2017. To put that into context, Samsung shipped between 75 million and 78 million smartphones last quarter. So, while this is a big deal, it's a fancy new line they were really trying to get some momentum behind, in the grander scheme of their product mix, it's actually maybe about 10% or so. I don't think it's as big of a deal as people realize.

Niu: I think the big difference is, a lot of Samsung's volume comes from these low-end, cheaper smartphones in places like India. They sell phones that are $50 to $100. They're not making a lot of money on that, but they ship a lot of units, which helps them keep their rank in the smartphone market. Like you mentioned, it's a lot more than Apple, 75 million on a non-holiday quarter, that's a ton of phones. But a lot of those are low-margin, low-value units versus these high-end phones -- that's where these companies make their margins. I think it has a leverage effect, in that it seems smaller in terms of units. But it had a pretty big impact on operating profits.

Generally speaking, mobile is about half of Samsung's business, in terms of revenue and operating profit, roughly, before this whole thing. Mobile includes a bunch of things, like tablet and these phones. But the mobile segment itself is incredibly important to them. Within the mobile segment if you look at the margin profile within their mobile business, these high-end phones are quite important in terms of profitability. Those low-end phones get a lot of volume, but considering that Samsung is largely a hardware player, if they sell a low-end phone to someone, it's not like they're capturing that customer on to their platform like Google or Apple would be. They're just trying to sell the phone. So, I think it won't have a huge impact on total volumes. But I think, again, coming back to the brand, it's so damaging for the brand. That's something that's really hard to put a number on right now -- brand valuation. I think that's the bigger thing here. Missing out on one product cycle is one thing, if it's contained within this product cycle. But if there's lasting damage to the brand, they could be hurting for a long time.

Lewis: I think that's why you've seen market reaction to this actually not be so bad. Short-term, if we're to take the company at the guidance that they're giving, and we look at the product mix, and they're able to hold the volumes on those other brands, the drop that we've seen makes sense. I think if you look back to when this story originally broke, the company was down about 4% or 5%, which really isn't all that crazy given that this is one of their most consumer-facing and high-profile lines. They do have so many other offerings in the smartphone market. If those hold, there shouldn't be too much of an issue there. One of the things people might not realize about Samsung is, they're a little bit more diversified than your Apple, in terms of the different hardware arenas that they've planned. To give you an idea of their revenue mix, consumer electronics is about 22% of revenue, and that does not include smartphones. IT and mobile communications, as you said before, a little over 50% of revenue. Device solutions, which is the semiconductor and display panel business, 36% of revenue. The IT and mobile is the highest-margin business that they are in, and having a high-profile phone, a high-ASP phone (average selling price), being removed, might lead to some margin compression there. But if they're able to hold on the other brands, I think this muted reaction from the market makes sense.

Niu: Yeah, I guess we'll just have to see if they can successfully pull off this crisis management. I think it's a good thing to kill those phones, definitely, especially when you don't know what's going on. You have to bite the bullet.

Lewis: Absolutely. In the second half of the show, we're going to hit briefly on a couple companies that might be poised to benefit as Samsung goes into crisis mode.

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So, Evan, we talked about how the premium side of the smartphone market could see some shake-up. We might see some consumers that were interested in the Galaxy line, maybe they were Galaxy Note owners, taking this opportunity to either try an iOS device, maybe another Android device. Do you think there are any big beneficiaries with this?

Niu: I think there are definitely some winners and losers. If we start with the loser list, I think it's a little bit shorter, because Samsung is mostly self-contained in terms of its suppliers. Samsung is so directly integrated that it makes most of the components that go to its phones. It still has some third-party part suppliers. But as far as supply relationships go that might suffer from reduced unit volumes, it's mostly going to be within Samsung itself. Qualcomm(NASDAQ:QCOM)probably loses a little bit because the Snapdragon 820 is inside the U.S. variants --

Lewis: Can you explain what the Snapdragon does?

Niu: Snapdragon is the main applications processor that has integrated modem and all these things. It's one of the most important pieces of any phone, the processor. Samsung, what they do is they have all these different variants for different geographies. Samsung has been trying to ship to its own in-house Exynos processor. I think the last year, they were exclusively Exynos, with no Snapdragon, but this year, Qualcomm has gotten back into the mix, they've improved their chips a little bit and got more competitive. There's some variance for different geographies, and Qualcomm is in the U.S. variance. So, they'll lose a little bit, since they obviously won't be selling into this phone anymore. But there's kind of a hedge, because Qualcomm does sell a lot into Apple. If people buy iPhones instead of the Note 7, probably incrementally negative to Qualcomm, but they're not totally out of the picture.

Lewis: Right, you might be a little pinched, but nothing crazy.

Niu: Right, there's a little bit of a hedge, there's a silver lining. And of course, it depends on which iPhone you get, because not Qualcomm has lost a little bit of spot in the iPhone, because Qualcomm used to be the exclusive modem supplier, and for the first time ever, Apple has gone to Intel -- well, first time not including Infineon 10 years ago. Now, this year, Apple is now buying modems from Qualcomm and Intel, depending on which phone you get. As far as pure winners, I would say certainly Apple.

Lewis: Yeah, I think they're up 10% since some of the products issues around the Note 7 surfaced. The market certainly seems to think --

Niu: Yeah, there was already iPhone 7 optimism, and now the shares just keep going higher. They're at 2016 highs because of all this stuff that's going on with Samsung. I think it's pretty clear that a lot of people are probably going to try. And we've already been seeing Android switching rates continue to rise every quarter. Apple touts this every quarter, every quarter they're like, "highest Android switcher rates ever." I think that trend is going to continue, particularly with one of the biggest Android OEMs hitting into this wall here.

As I mentioned, Intel is now in some of the iPhones. So Intel, to the extent that people are buying the phones with their modem, they benefit. Taiwan Semiconductor (NYSE:TSM), I think, is a big winner here too. They actually just released earnings that were pretty strong. Taiwan Semiconductor is producing Apple's A10 Fusion chip. Another change this year is that, in prior years, Apple had been dual-sourcing its chip manufacturing from both Samsung and Taiwan Semiconductor, which started one or two years ago. They only brought on Taiwan Semiconductor one or two years ago. But now, supposedly, with all the indications that we're getting, it's exclusively to TSMC, which is a huge win for them and a huge blow to Samsung, in terms of the foundry business on the chip manufacturing side. That's a lot more chips that Taiwan Semi is going to be making for Apple. They just released earnings; it was pretty strong, came in above expectations. I don't remember the exact numbers. But the important thing is that Taiwan Semiconductor raised fourth-quarter guidance, and that raised guidance did not factor in the possibility of these other phones being discontinued. So they were already super bullish, even before factoring in the Note 7's discontinuation into their forecast. So, I think they're really going to bank this holiday quarter if Apple sells enough phones. That's a ton of orders going to TSMC to make these A10 Fusion chips. I think they're probably a pretty big winner here.

Lewis: Yeah, I think a lot of people tend to read into the commentary we get from component manufacturers that go into the iPhone as a general baseline for how that segment might be doing when Apple reports again. If you're seeing guidance up from Taiwan Semiconductor, that probably bodes well for the iPhone business.

Niu: Yeah. And even before the Samsung Note -- that's what blew me away -- their guidance was so strong, and they literally said, "This does not include any impact if the Note 7 is discontinued," which it has been. So, it looks really good for them. As far as third-party carriers or retailers are concerned, I think they're pretty ambivalent. They're just trying to do their best to help their customers not be in danger. Their brands aren't going to be affected, and they're not going to be bearing a lot of cost because Samsung is going to be paying for all of this. So most of the retailers and carriers just want to do what's right for the customer and get these things off the market. I don't think there's going to be any damage to them.

Lewis: I've seen [Alphabet's] Google thrown around in the list of potential winners as well. The idea is kind of similar with Apple -- they released the Pixel phone somewhat recently. Having a major potential competitor off the table bodes well for people giving that a shot. That's not going to be something that meaningfully contributes to the numbers for Google. I think, when you're talking about Apple and Google here, seeing Samsung falter and knowing that there might be a slightly larger bite of the smartphone market available to them isn't something that's thesis-altering. It's certainly interesting for some of the component manufacturers that are specifically in some of these devices and not others. But big picture, if you like Apple and Google already, stick with them. But don't buy solely on the idea that they might pick up some incremental business here.

Niu: Yeah. The Pixel looks like a pretty good phone. Of course, it's Google's first phone, they designed the whole thing. They're outsourcing manufacturing, naturally, to HTC. But as far as them designing the phone itself, this is the first time that they're really doing the whole thing. It looks like a really good phone. I think, definitely, people that are not getting the Note 7 might consider the Pixel, because it's a pure Google phone stock Android without all the third-party software and all this stuff on it. But I think the biggest challenge there in terms of getting people to switch from a Note 7 to a Pixel XL or whatever the large one is called, it's really just about distribution. Google doesn't have distribution channels in the way that most companies in the space do. They're partnering with Verizon, which is the only carrier partner. Other than that, they're selling it online through the online store. But, it might surprise you how many people, when they need a new phone, they go to the carrier store. They just go to the retail store.

Lewis: It becomes kind of a default decision, right?

Niu: Yeah. And it makes some sense, because that's where they have the most selection, they can deal with all their plan stuff. I personally tend to buy things online, and I think a lot of people do. But, carrier distribution is an incredibly important channel for any phone maker. People that already know which phone they want they'll just go and buy that phone online. But a lot of people don't know, and they still like to shop around, like any other product in their lives, versus people like you and me are probably so loyal that it's not even a decision, it's just, when am I going to get my iPhone? But, for a lot of people, their phone breaks, or it's time for an upgrade, they just go to the carrier store and pick one. For the other carriers other than Verizon, Pixel's not going to be there, because Google is distributing themselves. It's harder for Google to get these carrier relationships going, because the carriers want more control. It's harder for Google to negotiate because they've never been a big player in the physical smartphone space. So I think the biggest thing that's going to hold them back is their lack of distribution.

Lewis: It sounds like the rundown for investors here is, Apple, Google, possible beneficiaries. The people that might really see some importance swings in what goes on with their numbers are some of the component manufacturers like you talked about, Taiwan Semiconductor. My feeling is, for Samsung's business, if they're able to keep the bad PR and negative brand association contained to the Note line, then this won't be something that's really awful for them long-term. If it does start to bleed into the other products they offer, the S7 and things like that, it could spell trouble for their mobile segment for a long time.

Niu: Yeah, the main thing is to figure out what the hell is going on with these things. Clearly, if they launch a phone next year and it has the same thing, that would thesis altering, two in a row. And, if they can't figure it out, there's reason to think that-there might be another one.

Lewis: Yeah, I think a lot of consumers want them to know exactly what's going on and tell the public. Then we might see a nice rally in Samsung sales.

Niu: They can't replicate this in their labs! It's just crazy.

Lewis: Anything else before I let you go, Evan?

Niu: No, I think we hit it all.

Lewis: Awesome. Well, listeners, that does it for this episode of Industry Focus. If you have any questions, or just want to reach out and say, "Hey," you can shoot us an email at industryfocus@fool.com. You can always tweet us @MFIndustryFocus. If you're looking for more of our stuff, you can subscribe on iTunes or check out The Fool's family of shows at fool.com/podcast. As always, people on the program may have own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. For Evan Niu, I'm Dylan Lewis, thanks for listening and Fool on!

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Dylan Lewis owns shares of Alphabet (A shares), Apple, Chipotle Mexican Grill, and Verizon Communications. Evan Niu, CFA owns shares of Apple. The Motley Fool owns shares of and recommends Alphabet (A and C shares), Apple, Chipotle Mexican Grill, and Qualcomm. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. The Motley Fool recommends Intel and Verizon Communications. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Author

Evan is a Senior Technology Specialist at The Motley Fool. He was previously a Senior Trading Specialist at Charles Schwab, and worked briefly at Tesla. Evan graduated from the University of Texas at Austin, and is a CFA charterholder.